Inheritance Tax Planning Trusts
These may come in various forms:
Transferable Nil Rate Bands
What do you mean by a transferable nil rate band?
A transferable nil rate band arises when one party to a marriage or civil partnership dies and the amount of their estate that is chargeable to inheritance tax (IHT) does not use up all of the nil rate band they are entitled to. Where this happens, the unused part can now be transferred to the surviving spouse or civil partner when they die.
How does that work then?
Everyone is entitled to a nil rate band for IHT. Assets that pass from one spouse or civil partner to another are exempt from IHT. So if on death, someone leaves everything they own to their spouse or civil partner, it is exempt from IHT and they have not used any part of their nil rate band. That unused nil rate band can now be transferred to their surviving spouse or civil partner and used in working out the IHT liability on their estate when they die.
Does it matter when the deaths occurred?
Yes - this applies where the surviving spouse or civil partner died on or after 9th October 2007. But it does not matter how long before then their spouse or civil partner died.
How much is the nil rate band?
For 2011/12 the nil rate band is £325,000
So you mean that if I inherited all the assets from my spouse or civil partner, my executors could add that nil rate band that applies when I die?
Essentially yes - but it works by looking at the proportion of the nil rate band that was unused when your spouse or civil partner died and up-rating the nil rate band available when you die by that same proportion.
What do you mean by up-rating the nil rate band available by the same proportion?
The amount to be transferred is worked out by taking the proportion of the nil rate band that was unused on the first death and applying that to the nil rate band available when you die. So if your spouse or civil partner left assets worth £162,500 to your children with everything else to you and the nil rate band on the first death was £325,000; one-half of their nil rate band is unused and is available to transfer. If, when you die, the nil rate band had increased to £375,000 for example, the amount available for transfer would be 50% of £375,000 or £187,500 giving your estate a nil rate band of £375,000 + £187,500, or £562,500 in total.
What if my spouse or civil partner was only worth £100,000, so that they did not need their entire nil rate band. Is the amount that can be transferred tied to the amount that they actually left me?
No - it doesn't matter what the size of the first estate was, whatever proportion of the nil rate band is unused may be transferred to you. If your spouse or civil partner's estate was worth only £100,000 and they left everything to you, they will not have used any part of their nil rate band. So 100% of the nil rate band is available for transfer when you die.
What about any gifts my spouse or civil partner may have made in the 7 years before they died; or any other assets that were chargeable when they died?
Gifts and any other assets that are chargeable on the first death (say assets in trust or assets owned jointly with a son or daughter) all eat into the nil rate band in the normal way and so reduce the amount that may be available for transfer.
The Nil Rate Band IOU Trust
Most couples leave everything to each other with the result that more tax is paid than is necessary - take the case of Mr Smith & Miss Jones. Between them their home, cash and investments amount to £650,000. Mr Smith dies first leaving everything to his partner. There is no tax on his death as the value of his estate is worth £325,000 which is the nil rate band. But if Mr Smith leaves everything to his partner, on Miss Jones's death, should she still be worth £650,000 then there would be a tax liability of £130,000.
What did Mr Smith and Miss Jones do wrong?
They failed to make the best use Mr Smith's nil rate band. By giving everything to his partner, Mr Smith inflated the value of Miss Jones estate and in turn made the taxman richer by £130,000 - what a waste!
Instead, Mr Smith might have given the £325,000 to his children. This would cut the tax bill by £130,000. The difficulty with this approach is that the surviving partner may need the £325,000 he has given to his children, It maybe therefore out of the question. This is particularly so where the home is your major asset, as you would have to give away part of your home to satisfy the gift of £325,000 - giving away part of your home is far too risky.
So what should Mr Smith and Miss Jones do?
Mr Smith and Miss Jones should make new Wills, but these aren't conventional Wills. They incorporate a special tax-saving technique called the Nil Rate IOU Trust.
The Nil Rate IOU Trust involves a special trust, which can make loans to the survivor. The Nil Rate IOU Trust enables Miss Jones to inherit her partner's entire assets subject only to a loan from the trust. In practice there is little to prevent her doing whatever she wishes with the assets. After her death all the assets pass to the children. The loan cuts down the inheritance tax on Miss Jones death, so the children receive an extra £130,000. How does this work?
All assets pass to his partner in return for an IOU for £325,000 given by her to the trust
Miss Jones has personal assets of £325,000
Mr Smith's assets £325,000
Miss Jones total assets amount to £650,000 (Less the IOU of £325,000)
On Miss Jones death: assets less tax pass to the children
Total £650,000 - less IOU £325,000 = £325,000 thus leaving no tax to pay
Balance left to children from Miss Jones estate of £325,000
During the life of Miss Jones there is a Trust containing an IOU for £325,000. On Miss Jones death the loan is repaid and the remainder of her estate, £325,000 is distributed to the children.
On receipt of the loan repaid from the estate of Miss Jones, the trust now pays out the £325,000 to the children of Mr Smith and Miss Jones. The children receive a total of £650,000 with not a penny tax to pay and Miss Jones did not lose access to all the assets.
In a nutshell, the Nil Rate IOU Trust saves up to £130,000 of inheritance tax, gives the survivor continued access to all your assets and safeguards the position of the survivor even when your main asset is your home.
The 2 Year Discretionary Trust
The Inheritance Tax Act 1984 s144 (IHTA 1984) provides that if distribution is made within two years of the testator's death out of a discretionary trust created by a Will then, the result for inheritance tax purposes is the same as if the Will had provided that on the Testator's death the property should be held after the distribution'. The result occurs automatically and inevitable.
It is impossible for any Testator to foresee exactly what will be the circumstances of his family or the value of his estate at the time of his death, even a carefully considered Will may well turn out not to be suitable at the time of the Testators death. A 2 year discretionary trust allows the Executors to decide upon the disposition of the estate, with the ability to distribute the estate in the most tax efficient manner.
The Residuary Discretionary Trust
Very similar to the above Discretionary Trust but only deals with the residuary estate. This allows the surviving spouse to make decisions over distribution after first death.
The Nil Rate Band Discretionary Trust
By including in your Will an outright gift to the children of the Nil Rate Band you will have reduced or even avoided any IHT liability. However, it is essential to balance your desire to reduce any IHT liability against the need to ensure that your spouse is able to maintain their standard of living after your death. At this moment in time it is not possible to know when you are to die, or to predict what your estate will be worth at your death, or to know what the needs of your spouse will be at that time, or to know what the Nil Rate Band will be at the time of your death. Therefore, incorporating an absolute gift of the Nil Rate Band to the children in your Will could leave the surviving spouse in dire circumstances.
Therefore, these problems can be overcome by creating a Discretionary Will Trust (rather than an absolute gift) of the Nil Rate Band, with the surviving spouse, children, and grandchildren as the potential beneficiaries of the Discretionary Trust. The Trustees of the Discretionary Trust have the total discretion as to which potential beneficiary or beneficiaries to pay either capital or income. Additionally the appointment of the surviving spouse as one of the Trustees of the Discretionary Trust provided the ability for the surviving spouse to have a considerable measure of control over how the Trustees exercise their discretions. The Will also effectively allows the surviving spouse to decide after your death (when they will have a much clearer idea of their needs) how much (if any) of the Nil Rate Band they must keep and how much can be given to the children.
Any capital or interest held in the Trust on your death would then pass to your children free of tax. Should the surviving spouse have not required any of the Trust Funds then the whole of your Nil Rate Band would pass to the children, free of tax and on the surviving spouse's death. The surviving spouse would also have their own Nil Rate Band to pass onto the children. Under such circumstances it is possible for both Nil Rate Bands to be utilised thus reducing the total amount of tax payable, without, placing the lifestyle of the surviving spouse in jeopardy.
In many estates the house is one of the major (if not the major) asset. Should an absolute gift of the Nil Rate Band be given and there were insufficient assets in the estate to satisfy the Nil Rate Band and the house (or part of the house) had to be used to satisfy the absolute gift of the Nil Rate Band, then the Capital Taxes Office would deem that the house (or part of the house) held in trust was an 'Interest in Possession' and the whole value of the house would form part of the surviving spouses estate for Inheritance Tax purposes, thus defeating the object of the trust.